Selling-at-a-Loss: Why the Cloud Is Threatened By Unprofitability

In creating a lot of hype about cloud computing, Silicon Valley is doing what it does best: minting young millionaires. But should investors be worried?

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2012 was a great year for the cloud. The industry grew by over 20%, hosting providers like Google (NASDAQ:GOOG) and Rackspace (NYSE:RAX) continued to build out their networks... and cloud software companies lost more money than ever. Salesforce.com (NYSE:CRM) tripled its 2011 losses, bleeding $111 million before taxes in 2012. Workday (NYSE:WDAY) was in the red by $107 million, and NetSuite (NYSE:N) was in the red by $32 million. The consumer side logged a similar performance: Pandora (NASDAQ:P) lost $38 million, or double its loss two years ago, and Netflix (NASDAQ:NFLX), which actually made money in 2011, came close to fixing that in 2012 as income fell 90%.

It's not surprising that these companies are unprofitable. The Web industry has always preferred to grow faster by selling products and services at below cost. Nor should it be unexpected that instead of finding their way to profitability, these businesses are losing more money each year. This is, after all, exactly what happened in the late '90s when the growth of dot-coms rarely translated into income. What's remarkable is that investors are, for a second time, buying into a strategy that burned them so badly in the past.

Software-as-a-service (SaaS) companies are the content providers of the cloud. After advertising, business processes (sometimes called BPaaS) and Web apps are the largest sources of revenue, with a 43% share, according to Gartner. So while we might think of data storage solutions like Dropbox as the quintessential cloud products, the future of the industry relies on the success of services like Intuit's (NASDAQ:INTU) TurboTax, or Salesforce on the enterprise side. They replace traditional software; instead of purchasing a program, you're renting one that never leaves the Web browser. This means lower fixed costs, which can be a real selling point for cash-strapped consumers and IT departments.

Of course, there's a tradeoff: Renting means that you're subject to changes in price, quality, and availability. These risks increase dramatically when the firm you're renting from is losing money.

Salesforce is one of the oldest and largest SaaS providers, with its core product being customer relationship management software – an online toolkit for salespeople. The company grew revenue 35% in 2012 and Wall Street applauded, bidding the stock up nearly 70% by yearend and giving it a $25 billion market cap. Meanwhile, Salesforce's selling, general, and administrative (SG&A) expenses rose 40% and operating margins fell to -3.6%, meaning that each additional dollar of revenue was marginally less profitable.

Workday and NetSuite are leaders in business management SaaS, and their problem is a little different. In 2012, Workday's operating margins improved from -58% to -39%, but because revenue doubled, absolute losses grew. NetSuite margins improved from -13% to -10%, but larger revenue meant that the result was the same: greater losses. In other words, as these companies become larger, they're seeing some benefits of scale, but those benefits are outweighed by the unprofitability of the core business.

These companies are not outliers. They're large and well-established, and they're given high market valuations. At current rates, however, none will grow their way to profitability. They'll be forced to raise prices (or cut services), and that brings into question the supposed cost savings of SaaS. If migration to the cloud has been driven (to some extent) by artificial pricing, that could spell trouble for the companies that have rushed headlong into cloud infrastructure, like Rackspace, Google, Amazon (NASDAQ:AMZN), and Microsoft (NASDAQ:MSFT).

Meanwhile, founders and initial investors are cashing out. Rumor has Dropbox planning an IPO later this year; if it does go public, it will be one of the last major players to do so. Smaller cloud companies are pursuing a simpler strategy: Get acquired. Salesforce made seven acquisitions in 2012 alone, and is now raising $1 billion in debt to fund further conquests. The longtime players of Silicon Valley – Cisco (NASDAQ:CSCO), Oracle (NASDAQ:ORCL), Dell (NASDAQ:DELL), and Hewlett-Packard (NYSE:HPQ) – have been happy to play their parts. They're buying up large swaths of cloud real estate -- not so much because it's additive to the bottom line, but because it provides them with "mind share" – that is, the illusion of a plan forward. More worrisome is the fact that growing numbers of non-tech firms are purchasing their way into this space. Ernst & Young reported that, in 2012, the cloud drove more mergers and acquisitions than any other sector, and that much of this buying interest originated in outside industries. Do they know what they're getting into?

HP didn't; that much is obvious from its $11 billion purchase of Autonomy. Autonomy, an enterprise software provider specializing in search, hosts one of the largest private clouds in the world. In 2011, it was in the right place at the right time. According to a recent Forbes article, HP CEO Leo Apotheker wanted to buy a company – any company – and Autonomy was the only one he could get. Last year, HP wrote down the firm's value by nearly $9 billion and made allegations about accounting irregularities, as Autonomy failed to perform as expected.

Oracle hasn't made any such allegations, but its cloud acquisitions haven't been accretive, either. The company disappointed investors when last month it reported revenue below expectations, with the stock shedding 10%. One can't help but wonder: Did Oracle make the mistake of trying to extract profits from this unprofitable industry?

Despite everything, the cloud is growing fast and, at the moment, Wall Street seems happy. Silicon Valley is doing what it does best: causing sensations and creating twenty-something millionaires. It's a familiar script, and the best that can be said for it is, maybe this time it's different.